Morgan Stanley expects the divergence between the S&P 500 and broader equity market participation to narrow over the coming month, with bond market volatility playing a central role in its outlook.
Strategist Michael Wilson said the bank expects market breadth and index levels to converge if volatility in fixed-income markets remains elevated.
“We lean toward a meeting in the middle if bond vol doesn’t calm down,” Wilson wrote.
Morgan Stanley continues to characterise the current environment as a mid-cycle equity market. The bank said earnings remain supportive while valuations have declined, with higher-quality companies accounting for a larger share of market leadership.
“The equity market is not complacent around the risks,” Wilson wrote.
More than half of Russell 3000 constituents have fallen by at least 20% since June, according to Morgan Stanley. At the same time, the S&P 500’s P/E ratio has declined to around 19 times, near its March low, while earnings for the median company continue to grow at a mid-teens rate.
“Market breadth improved through most of the summer even as energy prices and yields rose, while the momentum factor experienced one of its worst drawdowns in history,” Wilson added. “The recent narrowing in breadth occurred after Jackson Hole as the market priced a more hawkish Fed path.”
Morgan Stanley Outlines Two Paths for Market Breadth
If bond volatility remains elevated, Morgan Stanley expects the S&P 500 and broader market breadth to move towards each other over the next month. The bank subsequently expects a stronger finish to the year.
An earlier decline in bond volatility would produce a different scenario under the bank’s outlook. In that case, Morgan Stanley expects breadth to catch up with the index, potentially allowing both measures to rise.
Wilson continues to favour higher-quality large-cap companies, particularly asset-light businesses experiencing upward revisions to earnings estimates. He said he would add exposure to riskier equities if the index declines during the coming month.
Artificial intelligence adoption also remains part of Morgan Stanley’s earnings outlook. The bank said companies making greater use of AI are currently recording higher margins and earnings.
Consensus forecasts assume that these benefits diminish in subsequent years, according to Morgan Stanley. The bank said earnings estimates could therefore have further room to increase if AI-related financial benefits prove more persistent than currently assumed.